Types of Dividends

Table 2-1. Dividends: How Important Are They?
The average dividend yield on the 500 stocks in the Standard & Poor’s (S&P) Index
was 1.99 percent in May 2006, and the dividend payout ratio was 28 percent. In
other words, company managers retained 72 percent of company profits for their
own preferred uses.
So why are dividends important if companies pay such a small percentage in
dividends? The importance of dividends lies in their tax benefits.
In 2003, federal tax rates on qualified dividends were lowered to a maximum rate
of 15 percent if held for the required length of time. This lowered tax rate makes
investing in dividend-paying stocks more advantageous from a tax point of view
than many taxable bonds, where interest is taxed at the taxpayer’s marginal rate,
which can be as high as 35 percent.

Cash Dividends

A cash dividend is a dividend paid in cash. To be able to pay cash
dividends, companies need to have not only sufficient earnings
but also sufficient cash. Even if a company shows a large amount
of retained earnings on its balance sheet, it may not be enough to
ensure cash dividends. The amount of cash that a company has is
independent of retained earnings. Cash-poor companies still can
be profitable.

Most American companies pay regular cash dividends quarterly;
some pay dividends semiannually or annually. Johnson &
Johnson, the pharmaceutical company, pays quarterly dividends,
and McDonald’s pays an annual dividend. A company might
declare extra dividends in addition to regular dividends. An extra
dividend is an additional, nonrecurring dividend paid over and
above the regular dividends by the company. Microsoft
Corporation paid an extra dividend of $2 per share over and above
its regular dividend to shareholders of record holding the stock on
November 15, 2004. Rather than battle to maintain a higher amount
of regular dividends, companies with fluctuating earnings pay out
additional dividends when their earnings warrant it. Whenever
times were good for the automobile industry, for example, General
Motors declared extra dividends.

Stock Dividends

Some companies choose to conserve their cash by paying stock dividends,
a dividend paid in stock. The companies then recapitalize
their earnings and issue new shares, which do not affect its assets
and liabilities. Table 2–2 shows an example of a company’s balance
sheet before and after a 10 percent stock dividend.

Table 2-2
Effects of a Stock Dividend on a Company’s Balance Sheet

In this table, the “Total equity” section of the balance sheet is
the same before and after the stock dividend ($200,000). The
amounts that are transferred to the different accounts in the equity
section depend on the market value of the common stock and the
number of new shares issued through the stock dividend. Amounts
from retained earnings are transferred to the common stock and
additional paid-in capital accounts. In this example there are 10,000
additional shares that have a market price of $5 per share. The
“Retained earnings” account is debited (deducted) for $50,000
(market price of $5*10,000 shares), and $10,000 (10,000 shares * $1 par value) is added to the common stock account. The other
$40,000 ($4 premium over par value * 10,000 shares) is added to
the additional paid-in capital account.

Receiving a stock dividend does not increase shareholders’
wealth. Shareholders who receive a stock dividend receive more
shares of that company’s stock, but because the company’s assets
and liabilities remain the same, the price of the stock must decline
to account for the dilution. For shareholders, this situation resembles
a slice of cake. You can divide the slice into two, three, or four
pieces, and no matter how many ways you slice it, its overall size
remains the same. After a stock dividend, shareholders receive
more shares, but their proportionate ownership interest in the
company remains the same, and the market price declines proportionately.

Stock dividends usually are expressed as a percentage of the
number of shares outstanding. For example, if a company announces
a 10 percent stock dividend and has 1 million shares outstanding,
the total shares outstanding are increased to 1.1 million shares after
the stock dividend is issued.

Stock Split

A stock split is a proportionate increase in the number of outstanding
shares that does not affect the issuing company’s assets, liabilities,
or earnings. A stock split resembles a stock dividend in that
an increase occurs in the number of shares issued on a proportionate
basis, whereas the assets, liabilities, equity, and earnings remain
the same. The only difference between a stock split and a stock
dividend is technical.

From an accounting point of view, a stock dividend of greater
than 25 percent is recorded as a stock split. A 100 percent stock
dividend is the same as a two-for-one stock split. Acompany might
split its stock because the price is too high, and with a lower price
the company’s stock becomes more marketable.

The following example illustrates what happens when a
company declares a two-for-one stock split. If at the time of the
split the company has 1 million shares outstanding and the price of
the stock is $50, after the split the company will have 2 million
shares outstanding, and the stock will trade at $25 per share.
Someone who owns 100 shares before the split (with a value of
$50 per share) would own 200 shares after the split with a value
of approximately $25 per share (50 / 2). On January 16, 2003,
Microsoft Corporation announced a two-for-one stock split that
took effect on February 18, 2003. Before the split, Microsoft closed
at $48.30 per share. On the morning of the split, it opened at $24.15
per share. An investor with 100 shares before the split would have
had 200 shares after the split.

Occasionally, companies announce reverse splits, which reduce
the number of shares and increase the share price. A reverse split is a
proportionate reduction in the number of shares outstanding without
affecting the company’s assets or earnings. When a company’s
stock has fallen in price, a reverse split raises the price of the stock to
a respectable level. Another reason for raising the share price is to
meet the minimum listing requirements of the exchanges and the
Nasdaq market. For example, a stock trading in the $1 range would
trade at $10 with a 1-for-10 reverse split. The number of shares outstanding
would be reduced by 10 times after the split. On November
19, 2002, AT&T had a reverse stock split of one-for-five shares. See
Table 2–3 for a discussion of whether there are any advantages to
stock dividends and stock splits.

Table 2-3
Are there Advantages to Stock Dividends and Stock Splits?
If shareholder wealth is not increased through stock dividends and stock splits, why
do companies go to the trouble and expense of issuing them?
The first advantage for the issuing company is a conservation of cash. By substituting
stock dividends for cash dividends, a company can conserve its cash or use it for
other investment opportunities. If the company successfully invests its retained
earnings in business ventures, the stock price is bid up, benefiting shareholders.
Consequently, shareholders are better off receiving stock dividends, but there are
costs associated with the issue of stock dividends. Shareholders pay the cost of
issuing new shares, the transfer fees, and the costs of revising the company’s
record of shareholders.
Advocates of stock dividends and stock splits believe that a stock price never falls
in exact proportion to the increase in shares. For example, in a two-for-one
stock split, the stock price might fall less than 50 percent, which means that
shareholders are left with a higher total value. This conclusion has not been
verified by most academic studies. When the price of the stock is reduced
because of the split, the stock might become more attractive to potential
investors because of its lower price. The increased marketability of the stock
might push up the price if the company continues to do well financially;
stockholders benefit in the long run by owning more shares of a company
whose stock price continues to increase.
Stock dividends and stock splits do not increase stockholder wealth from the point
of view of the balance sheet. Cash dividends, however, directly increase a
shareholder’s monetary wealth and reduce the company’s cash and reinvestment
dollars.

Property Dividends

A property dividend is a dividend paid in a form other than cash or
the company’s own stock. Aproperty dividend is generally taxable
at its fair market value. For example, when a corporation spins off
a subsidiary, shareholders might receive assets or shares of that
subsidiary. Distributing the stocks or assets of the subsidiary
(rather than cash) allows shareholders to benefit directly from the
market value of the dividends received.

Special Distributions

Companies sometimes make special distributions in various forms,
such as extra dividends, spin-offs, and split-offs.

Extra Dividends Companies might want to distribute an
extra dividend to their shareholders on a one-time or infrequent
basis. A company might have had a particularly good quarter
financially, or other reasons for this distribution might exist. The
company might use a special distribution rather than increase its
regular dividends because the distribution is a one-time occurrence.
Companies would not want to increase their dividend rates if they
could not continue paying those increased rates in the future.

Spin-Offs A spin-off is the distribution of shares of a subsidiary
company to shareholders. Some companies allocate proportionately
to their shareholders some or all of their shares of a subsidiary company
as a spin-off. For example, on August 9, 2005, IAC/InterActive
Corporation (ticker symbol IACI) spun off Expedia Corporation
(ticker symbol EXPE) to shareholders to allow it to focus on its business.
Prior to the spin-off (August 8, 2005), InterActive Corporation
had a one-for-two reverse stock split. For every two shares of
InterActive Corporation common stock owned as of August 8, 2005,
shareholders received one share of InterActive Corporation and one
share of Expedia common stock. Shareholders have the option of
keeping or selling the additional shares they receive. Companies
spin off unrelated or underperforming businesses to shareholders so
that they can concentrate on their own business. In many cases the
shares of spin-off companies outperform their parent companies
because the new stand-alone companies can expand in directions
where they are no longer hindered by their parent companies.

Split-Offs A split-off is the exchange of a parent company’s
stock for a pro-rata share of the stock of a subsidiary company. Splitoffs,
which differs from spin-offs, do not occur frequently. In a splitoff,
shareholders are offered the choice of keeping the shares they
own in the existing company or exchanging them for shares in the
split-off company. For example, on August 10, 2001, AT&T completed
a split-off of Liberty Media Corporation. AT&T redeemed
each outstanding share of its class A and class B Liberty Media
tracking stock for one share of series A and series B common stock,
respectively, from Liberty Media. In a split-off, an exchange of
shares takes place, whereas in a spin-off, shareholders receive additional
shares in another company.

Although shareholders obviously benefit from receiving dividends,
they also benefit when earnings are not paid out but instead
are reinvested in the company. This technique increases the value
of the company and hence the value of its stock.

Table 2–4 discusses dividend reinvestment plans for investors
wishing to reinvest their dividends directly in the stock of the
companies they already own.

Table 2-4
What Are DRIPS?
A dividend reinvestment plan (DRIP) allows shareholders to reinvest their dividends in
additional stock rather than receiving them in cash. These plans are offered directly
by companies or through agents acting on behalf of the corporation. In the former
case, a company issues new shares in lieu of cash dividends. You also have the
option of purchasing additional shares from the company. The advantage is that you
pay no brokerage fees, although some companies charge fees for this service.
The other type of plan is offered by agents, such as banks, that collect the
dividends and offer additional shares to shareholders who sign up for the plan.
The bank pools the cash from dividends and purchases the stock in the
secondary market. Investors are assessed fees, which cover the brokerage
commissions and the fee charged by the bank.
The advantage of DRIPs to shareholders is that they act as a forced savings plan;
dividends are reinvested automatically to accumulate more shares. This method is
particularly good for investors who are not disciplined savers.
A disadvantage of DRIPs is that shareholders need to keep, for tax purposes,
accurate records of the additional shares purchased. When additional shares are
sold, the purchase price is used to determine whether there is a capital gain or
loss. These dividends are considered taxable income whether they are received in
cash or automatically reinvested in additional shares. Another disadvantage of
DRIPs is that the fees charged to participate in this program can be high.